Getting Beyond Getting Government Out of the Way: A Review of The Captured Economy
Imagine responding to our current political moment by thinking the opposition to Trump should be rooted in libertarianism. It’s the argument put forward in The Captured Economy (TCE), by Brink Lindsey and Steve Teles. In it, they want to build a political project around challenging inequality by attacking regressive regulations, or “government policies [that] restrict and distort market competition through entry barriers and subsidies.” These regressive regulations are generally “government policies that create rents in the form of entry barriers or subsidies.” Their book discusses four key categories: financial regulations, intellectual property, occupational licensing, and land use.
These topics are fine as far they go, but the book wants to be more than the sum of a handful of policy chapters. TCE wants to make two major statements. First, they argue that regressive regulations are central to the story of how high-end inequality has grown and why the economy struggles overall. They aren’t focused on regulations that create rents for those at the bottom, like the minimum wage. Instead, they note that the “main rent-creating policies that have emerged and grown in recent decades have a much tighter focus on helping out those at the top.” Their second statement is that they argue that a focus on regressive regulations can create a new interesting political framework, scrambling the left and right into new ways of thinking that can tackle both our economic problems and our political gridlock.
Being the area I know best, I turned first to the chapter on financial reform. The argument there was a mess, but it was a mess in a very productive way, one that showed why the whole book isn’t up for the task it sets up for itself. Though I share their interest on several of these issues, (1) the book fails to convince that regressive regulations are behind what they discuss and (2) the concept of regressive regulations won’t do any good in helping our politics, or even answering the big questions we face.
Did FDIC Cause Financialization?
In The Captured Economy (TCE), Lindsey and Teles argue that one of the substantial causes of financialization is the “large and destabilizing subsidies” from the government to the financial sector, which in turn have negative distributional and allocative effects. They acknowledge that there were “sins of omission” in finance, where the government simply didn’t act to stop abuses — a topic that goes beyond the scope of the book.
Instead, Lindsey and Teles focus on sins of “commission,” identifying three such regressive regulations. First, there’s a “regulatory subsidy” for mortgage-backed securities (MBS), a creation that was “invented, developed and nurtured by the” government for the quasi-public government-sponsored enterprises (GSEs). Then, there are two “main explicit subsidies.” The second consists of an “implicit safety net” of emergency lending and bailouts that “has extended far beyond the traditional banks.” This Too Big to Fail (TBTF) subsidy allowed finance to borrow artificially low interest rates before the crisis and thus grow far too big. The final is a poorly priced and too expansive guarantee for depositors. “Deposit insurance [acted] to subsidize heavy reliance on deposit to fund banking operations.”
Let’s take these backwards. It is very difficult to tell a story of financialization in which deposits play an increasingly dominant role in the financial sector over the past 30 years, or one where they were a major driver of losses in the housing crash. If this was the case, we’d expect to see deposits growing as a share of total funds and that their losses would be higher on average from housing losses. Neither is correct.
One of the key things about the changes to the financial sector since the 1980s has been the relative decline of traditional banking as a core focus. Figure 1 shows that deposits held by banks, which have an “explicit subsidy” TCE identifies, falling from 60 percent of GDP in the mid-century period, to closer to 40 to 45 percent. It also shows short-term liabilities outside traditional deposits — shadow banking financial instruments like repurchase agreements, commercial paper, and money market mutual funds — rapidly expanding, overtaking deposits in 1997. More broadly, the percent of financial assets held by depository banks declined from 40 percent in the mid-century period to 20 percent after 1980. It’s difficult to tell a story of financialization that results from the increasing power of depositors subsidized through regressive regulation when their relative presence is in decline.
Deposit institutions’ mortgage losses were small compared to growing mortgage securitization. One estimate by Mark Zandi, consistent with many others analysts, has depository institutions realizing losses of 5.8 percent of mortgage debt from 2006 to 2012 (Zandi 2011). This is higher than the 3.7 percent losses of the GSEs, but much lower than the 20.3 percent losses of private-label mortgage securities. If financialization is about depositors not disciplining the balance sheets of their banks, why were their losses so much less than those in the capital markets?
Meanwhile, it is difficult to tell a story where the second explicit subsidy, a TBTF subsidy that allows the biggest players to borrow more cheaply, accounts for the growth of the financial sector before the crisis. Studies pre-crisis differed, but in general they weren’t looking at the shadow banking market where the risk was. Two notable studies post-crisis find no substantial subsidy in the United States before the crisis, though they find them increasing dramatically from 2009 to 2011, before decreasing significantly (IMF 2014, GAO 2014). One quick sanity check here: If banks take on more risks than they would have otherwise because of a TBTF subsidy, this would increase the risks equity holders face, since equity takes the first loss. If this is an important mechanism, then TBTF equity should have flat or increasing levels of risks in the buildup to the crisis. We see the opposite.
Figure 2 shows the covariance of stock prices with the overall market — a common financial measure for equity risk known as “beta” — for four of the largest banks: Citigroup, Wells Fargo, Morgan Stanley, and Goldman Sachs. A higher number reflects that a firm moves more with aggregate market changes, and thus contains more risk. We can see that all four of these banks’ beta decline dramatically from the 1990s through the crisis. They have numbers less than 1, implying a very safe institution. This says that even equity holders didn’t see the banks as risky. Note that this number skyrockets during the the aftermath of the crisis, when the TBTF subsidy was real.
It’s not clear why it is necessary to pin the financial crisis on the government. There is limited cognitive bandwidth, and spending time on these issues means less for the real problems. It is probably counterproductive; weaker FDIC insurance would have meant more credit intermediation in the shadow banking sector, where the real, documented problems were. But if you are going this route, you should be able to point to actions that matches the severity of the problem. I do not believe these subsidies are a driver of any major financial sector trends. If they even exist, they are at no level to explain the vast growth in the nature and profitability of the financial sector over the past 30 years.
Quod Erat Demonstrandum
According to the latest research (Johnson 2017), the recent growth of occupational licensing causes “the number of annual interstate migrants [to be] reduced by 93,600” and “explains 6 percent of the decline in interstate migration and 2 percent of the decline in job-to-job flows over this time period.” That’s percent, not percentage points, so it doesn’t explain 98 percent of the decline in job-to-job flow — and the labor market is about 160 million people. I’ll leave it to you to determine if that’s a crisis, but how does occupational licensing drive the 1 percent? Is that about owners and bosses making out like bandits?
TCE argues it is because 1 percent incomes are driven by licensing. One of their key arguments is that while people “may think of Warren Buffett and Marc Zuckerberg when they envision the top 1 percent, it is actually the surgeon who replaced their hip, the dentist who performed their last root canal, or the lawyer who handled their divorce who are the more typical representatives of that elite demographic.”
There’s no source for this, because it is obviously untrue. Figure 3 is a reprint from the best IRS data we have on occupations within the top 1 percent (Bakija 2012). Medical professionals (15.7 percent) and lawyers (8.4 percent) together are less than executives in non-finance (31 percent), and even less with those executives combined with workers in finance (13.9 percent). Doctors and lawyers also haven’t increased their presence in the top 1 percent over this time period.
But even if we wanted to focus on lawyers and doctors, why would we focus on their licensing as a driver of their high-end incomes? TCE seems to argue that there are high-end rents in these occupations, and, as we know, these occupations have licensing, so therefore the licensing must be the driver of the rents. (QED motherfucker.)
That doesn’t seem correct, and they don’t provide sourcing to really argue it. They note that it is “seemingly paradoxical” that “the United States has far more lawyers per capita than other countries” yet high-end lawyers make a substantial premium over other countries. But why wouldn’t we look at the activities of lawyers as the driver? There’s been a giant increase in the supply of lawyers since the 1980s, yet their presence in the top 1 percent is unchanged. And this makes sense, as top-end lawyers are taken from only the top 5, 12, or 20 law schools. More lawyers at the margins won’t compete away these high-end rents.
For medicine, they argue that “while failing to serve the interests of patients well, medical licensing is very effective in boosting physicians’ incomes.” Their source on medical pay just determines that doctors are paid more in the U.S. than elsewhere (Laugesen 2011), concluding that it is driven by higher fees but not by physician supply. They note that our supply of doctors per population is higher than the U.K. and about the same as Canada and Germany. Which, of course, makes sense; those countries don’t control their health care costs by having weaker licensing or having a very high population of doctors, but stronger pricing controls. (Ironically, one hypothesis their source has is that “High physician fees in the United States may reflect the cost of attracting skilled candidates to medicine in a society with a relatively more skewed income distribution.”)
Regulatory Subsidies and Rents Have a Question-Begging Baseline Problem
Even if the numbers don’t add up, maybe a focus on regressive regulations is a useful political tool? Lindsey and Teles have had a major victory already. In their book, they argue that “the lax rules for allowing class action lawsuits [creates] heavy dependence on high-priced legal expertise to navigate the artificial and gratuitous complexities of the legal environment.” This places lawyers in the top 1 percent, a regressive regulation that allows them to collect rents. The Republicans, perhaps after reading a copy of TCE, voted to repeal a rule from the Consumer Financial Protection Bureau (CFPB) that removed mandatory arbitration from financial products, giving consumers the option for a class action lawsuit. That was a win for TCE’s arguments against rents. Yet I’d argue the opposite, however, as these are rents for the financial sector. Mandatory arbitration incentivizes financial institutions to nickle-and-dime their consumers. It removes consumers’ rights as citizens to go to the courts. It gives finance more power when they already abuse the power they do have.
Whatever you make of that debate, does calling one side or the other “rents” help clarify it? I’d note that the focus on regressive regulations doesn’t actually clarify anything. I’d argue that for all the major problems we face now, the notion of emphasizing economic freedom and getting the government out of regressive regulations will do virtually no analytical work. “Get rid of the rents” (or even “economic freedom”) is meaningless here, because the question revolves around how we structure markets in the first place.
Think of some of the major debates in financial regulations: Should financial transaction be subject to a tax? Should private equity income be taxed as labor income? Should derivatives go to the front of the line in bankruptcy? Should there be a special legal regime for the failure of a financial firm outside bankruptcy? What should be the safe harbor for someone who makes a subprime mortgage that fails? Should there be a dedicated consumer regulator with power over unfair and deceptive practices? Should firms with access to deposit insurance be limited in their size or scope of activities? How much transparency should be mandated in markets for derivatives and hedge funds?
TCE describes the changes in regulatory structure during the 1980s and 1990s as a way to inhibit competitions and put up barriers. But the arguments for them at the time said that not doing them were what was really inhibiting competition. TCE argues, as traditional banks did at the time, that the lax oversight of money market mutual funds and mortgage-backed securities were a form of “regulatory subsidy.” Yet at the time proponents argued that tighter regulations on these new instruments would have benefitted traditional banking as its own form of regulatory subsidy.
Think of the major economic problems we faced in the recent decade: Is the wave of mergers and acquisitions consistent with the consumer welfare standard or antitrust, and do we need to go beyond that standard? Should public options like Medicare use its footprint to drive down health care costs? What is appropriate monetary and fiscal policy in a low-interest rate environment? How we should analyze and tackle market power? Or consider all the big questions of the Trump era: What should be the tax base? At the margins, who should be able to claim income from profits and who should claim income from wages? (Given that the top 1 percent takes home 50 percent of pass-through business income and that progressive taxation has kept top incomes in check in the past, the tax code is oddly missing from the book.) Should ISPs be indifferent to the source of their traffic? Should there be a mandate to purchase private health care? If all lower corporate taxes do is drive up share buybacks is that good or bad?
All of these have an intractable “baseline problem.” Each side of the question provides a benefit for some actors and a barrier for others. To try and judge them in terms of just getting rid of the rents and subsidies won’t get us very far. The concept of economic liberty can do no clarifying work here, and these answers aren’t just a matter of technocratic tinkering. The structuring of our markets — embedded in the laws, norms, institutions, and enforcement — determine how economic activity is exercised, and there’s no pre-state liberty baseline to draw upon. One could say that the answer is whatever involves the least amount of government, but that’s just generic anti-statist libertarianism, precisely what this book wants to transcend.
TCE argues that this agenda allows liberalism to “show that it can once again be a genuine fighting faith rather than an anemic justification for the status quo.” Yet, if one is around Washington D.C., one has heard this agenda for a while. You can feel the lanyard thick on your neck at some think tank luncheon; you can hear the polite chatter at the posh townhome of some #NeverTrump lobbyist. We live in a world characterized by inequality, weak dynamism, secular stagnation, high concentration, insecurity, large capital profits and market power. To the extent the book tries to tie their agenda, whatever you make of it, to these problems, it bounces off. To respond to both Trump and this moment, we are going to need more than just the same old “getting government out of the way.”